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Variable-rate Loans
Variable rate loans (also known as Adjustable Rate Mortgages or ARMs) have an interest rate that changes every so often. The interest rate is usually tied to some other interest rate that some financial institution calculates according to its view of the current state of the economy. The initial interest rate starts out lower (usually substantially lower) than what is available for a fixed-rate loan. Then, as economic conditions change, the rate can rise or fall.
It's not obvious, but this type of loan reflects pretty low risk for a mortgage company. And here's why. With a fixed-rate loan, the mortgage company is locking in a certain amount of interest that it will earn on the money it loans to you. But if interest rates rise, they could get more money from your loan if it were made today; however, because that money is tied up in your loan, it's not available to earn a higher interest rate. If the company could "untie" this money, they could make higher profits by loaning it at a higher rate.
However, with a variable rate loan, the mortgage company doesn't run the risk that it will be stuck getting low-rate interest payments if rates rise. This lower risk allows the mortgage company to offer you a low initial rate.
It won't be a surprise that the lower risk to them is your higher risk. If interest rates rise, you will see your costs (mortgage payment) go higher, perhaps dramatically higher. Then again, it's always possible that interest rates (and your costs) could drop.
So while you're taking on greater risk, you're also creating the possibility of having lower costs. Certainly your costs start out low; and depending on economic conditions, they could stay low or go even lower. This is the "Increased Risk = Increased Profit" formula in action as seen from your point of view:
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Increased Risk = (Possibly) Reduced Costs
Despite the chance for low costs, you don't want to lose sight of the substantially higher risk you take on. Measure it carefully. If you eventually end up being unable to make your payments, the increased risk will not have been worth the potential cost savings.
Interest-only Loans
Interest-only loans have become very popular recently. They offer the promise of incredibly low monthly payments. As a result, many people have flocked to them as an affordable way to get a loan.
This type of loan happens to embody a fairly large amount of risk. And while it offers low costs early in the term of the loan, the later costs are quite high.
The typical interest-only loan is a hybrid loan that is a cross of a fixed-rate loan and a variable-rate loan. Its initial low costs result from the fact that early in the term of the loan, you only pay interest on the loan. This differs from fixed-rate and varible-rate loans, because with those loans your monthly payment includes an interest payment and a principle payment. The principle portion of your payment is used to reduce the amount of the money that you borrowed. It is the principle payment that eventually allows you to pay down the amount you borrowed so that you pay off your loan.
With an interest-only loan, your monthly payment does not include any payment of principle. You only pay the interest due on the loan for the preceeding month. The absence of the priciple payment makes your monthly payment less than it otherwise would be under other types of loans.
In addition the interest rate during the early part your loan period is variable. So it starts out lower than the interest rate for a fix-rate loan (for the same reasons we discussed above under variable-rate loans). This lower interest rate further reduces your monthly payment.
For example, let's assume you take out a 30-year interest-only loan. For the first ten years, the loan is a variable-rate loan where you only pay the monthly interest. For years 11 through 30, the loan becomes a fixed-rate loan with a fixed monthly payment. But consider what this means.
At the end of ten years, the amount of money that you owe on your loan is the same as it was on day one. Now you have 20 years to pay if off instead of the 30 you would have had with a fixed-rate loan. So starting in year 11 your mortgage payment will jump dramatically.
You can see that the Pay Me Now or Pay Me Later formula still applies. What you avoid paying in the early years you will make up by making much higher payments in the later years. This represents substantial risk later in the loan. Also, because of the variable interest rate in the early years, you take on the additional risk of a variable-rate loan (as we discussed above).
Because the risk is high, the total potential costs can be low. Certainly, during the early years of the loan, the low monthly payment gives you the opportunity to save substantial amounts of money. Then, by the time the interest-only portion of the loan ends, chances are good that your home will have increased substantially in value. Similarly, you will likely have a higher income. Therefore, the sudden increase in payment may be easily affordable by then, and it may represent a reasonably small mortgage payment compared to the increased value of your home.
However, just like the variable-rate loan, you will want to be careful not to minimize the risks. If you reach a point where you eventually cannot afford the monthly payment, the cost savings that were potentially available to you will do nothing to keep you from possibly losing your home and ruining your credit.
